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Uses and Abuses of Gresham's Law
in the History of Money

by Robert Mundell
Nobel Prize for Economics, 1999

 

9. Gresham's Law Under Bimetallism

An understanding of Gresham's Law was crucial to the formulation of a correct monetary policy, and it turned out to be especially important under bimetallism. Bimetallism was a system in which one of more countries fix the prices of two of the precious metals in terms of the national currency unit, thus fixing the bimetallic ratio. In the following discussion, I shall assume that the two metals are gold and silver, but the theory applies equally to other metals.

Consider the operation of Gresham's law under bimetallism. Its principles can be studied best in the context of a small country facing a bimetallic price ratio in the rest of the world over which they had no influence. This was not far from the actual situation facing many countries between the end of the Middle Ages until 1873, when bimetallism gave way to the gold standard. To fix ideas suppose the bimetallic price ratio is 15.12:1, and that there is free coinage in the sense that people can bring either of the metals to the mint to be coined.

Suppose now that a new small country arrives on the scene and it sets its bimetallic ratio at 15:1. At this ratio the mint price of gold is lower and the mint price of silver is higher than the world price. In this situation, silver will be brought to the mint to be coined, but no one will bring gold to the mint when its price is lower there than it is abroad.

There would be perpetual disequilibrium if the market price ratios at home and abroad remained different. Equilibrium can exist only when the market price of gold at home has risen to the international level of 15.12:1, which is possible only when all the gold has left the country and the circulation is entirely silver. By overvaluing silver, the country, while nominally bimetallic, has put itself onto a de facto silver standard. Overvaluing a metal makes it "bad money" and brings Gresham's Law into play.

The opposite situation applies if the countries overvalues gold. Suppose the bimetallic ratio is set at 16:1 while, as before, it is 15.12:1 in the rest of the world. In this case the underpriced silver will be exported, gold will be imported and equilibrium will prevail only when the entire circulation is made of gold. By overvaluing gold, the countries moves onto a de facto gold standard. Again Gresham's Law worked when the bad money, in this case overvalued gold, drove out silver.

These examples are not abstract possibilities. They apply precisely to the United States after Alexander Hamilton created the bimetallic system by the Act of April 2, 1792. The dollar (which had been adopted as the monetary unit by the Congress of Confederation in 1786) was defined as 24.75 grains of pure gold and 371.25 grains of pure silver, implying a bimetallic ratio of 371.25/24.75 = 15. At this time the dominant monetary power was France which had in 1785, under Calonne, the able Treasurer-General of Louis XVI, established a bimetallic ratio of 15.12:1. It was by no means clear when the French Revolution began in 1789 what the bimetallic ratio would be in the future; Hamilton had to decide at a time when the international situation was unstable. As it turned out, he guessed wrong. When Napoleon (now Emperor) wanted to reestablish French credit in 1803 he set France back onto bimetallism at the Calonne ratio of 15.12:1. This made silver overvalued and gold undervalued in the United States. As a result the United States was de facto on a silver standard for the first four decades of its history.

In the early decades of the fledgling republic, complaints were heard over and over that gold coins were not available. Discussion continued in Congress until finally, on July 31, 1834, the long-sought reform measure was passed. Astonishingly, at a single blow, the gold dollar was reduced to 23.2 grains, and soon after, the Act of July 18, 1837, to 23.22 grains, the standard being changed at the same time from 11/12 fine to 9/10 fine. This made the bimetallic ratio 16:1. Now gold was overvalued, silver fled and gold rushed in, putting the United States de facto on the gold standard.(52) Silver dollars became extinct and emergency measures came to be required to retain within the country a sufficient amount of small change: the amount of silver in the subsidiary coinage from the half-dollar downward was reduced.(53) Overvaluing gold put the United States (de facto) on the gold standard.

The standard of a country could also be affected by a change in supply conditions in the precious metals industries. This happened to France in the 1850s. As we have seen France was theoretically on a bimetallic standard at a ratio of 15.12:1 from 1803 until 1870, but in fact most of its currency in circulation was silver. But in the middle of the century there came large gold discoveries: Russia in the 1840s, and the United States and California in the 1850s. This lowered the market price of gold below the French buying price with the result that France exchanged its silver for a gold currency. Gresham's law applies here also because the new supply conditions made gold the overvalued metal in France.

An equally famous example concerned Britain's movement toward the gold standard in the 18th century. The recoinage of the late 1690s had been a failure. Before the recoinage was complete, drawing on a report that was signed by Locke among others, the House of Commons established(54) a ratio of 15.12:1 at a time when the ratio in Holland (which at that time was the center for the precious metals markets) was 15:1; this was accomplished by rating the gold guinea at 21.12 instead of 22s. As a result about a 5 percent profit could be made by importing gold and having them minted into guineas, with the result that gold came to Britain and most of the newly-coined silver was exported.

By 1717 the situation had worsened and there was considerable agitation to prevent further losses of the silver coinage. To deal with the problem, much use was made of the brilliant report on the bimetallic ratios in different countries by Newton, Master of the Mint. It was concluded that the correction of the situation required a lowering of the value of gold relative to silver, with the result that the guinea was henceforth to be rated at 21 shillings. However, this reduction in the price of gold was not enough to erase the discrepancy between the English and Dutch ratios. With the guinea at 21s. the ratio was still 15.21:1 whereas in Holland and France, with increasing supplies entering Europe from Brazil, it was 15:1 or under. For this reason the practice of culling and exporting the heaviest silver pieces continued. A few decades later, by the accession of George III in 1760, the crown (silver) pieces had almost entirely disappeared and after 1774, when silver was partially demonetized, Britain had stumbled onto a de facto gold standard.

The models established above have assumed a small country faced a given bimetallic ratio in the rest of the world. This assumption, while simplifying the exposition, is by no means necessary. More generally the bimetallic ratio is determined by the interaction of the demands and supplies of the two metals in all the countries in the system. Bimetallism usually requires that at least one large country fix the ratio. Only a large country could "command" the ratio for any length of time; two or more large countries could ensure that it lasts even if their legal ratios were slightly different. Suppose that a large country fixes the ratio at 15.12:1 while other countries choose the same or different ratios. If the 15.12:1 ratio is consistent with market conditions, the large country will be on a bimetallic standard. Those countries that have fixed the ratio below that rate will have overpriced silver and put themselves on a silver standard; whereas those that have chosen a higher ratio will be on a gold standard. In a world of bimetallism, pluralism is the rule rather than the exception with so

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